Options and Okinawa

Before we get into discussing options, I would like to publicly announce that my daughter and her partner came in second place in the mixed doubles competition of the season-ending Far East High School Tennis Tournament, and following the tournament she was named to the All Far East team. In the championship match against a team from Seoul American High School, she and her partner won the first set 6-2, but then unfortunately dropped the next two sets. Congratulations!

My daughter's championship match was very similar to the attempt by the world's central banks to hold down the price of gold earlier this week when it was approaching the psychologically important $800 mark. The central banks, in cahoots with large commercial speculators who hold large short positions in gold, were able to hold the gold price down below $800 for about a day, but ran out of ammunition on the second day and were completely overwhelmed as gold soared to close to a price of $850 per ounce within 48 hours of breaking past the wall of resistance at the $800 mark. Expect something similar to happen around $850 and $900 as well.

In the last post, we discussed ways to buy Exchange Traded Funds (ETF's) that would profit from the rise in gold. Today we will discuss how to juice up the returns from ETF's using the leverage of stock options. An option is just what it sounds like - it is a contract that gives you the "option" of purchasing 100 shares of the ETF or stock in question at a set price on a set date in the future. The set price is referred to as the "strike price," and the set date is referred to as the "expiration date." Options that are purchased to bet on a rise in the price of the stock are referred to as "call" options, and options that are purchased to bet on a fall in the price of a stock are referred to as "put" options.

For example, the best option to purchase if you believe that GDX, an ETF composed of a wide variety of unhedged gold mining companies, will be going up in value would be the January 2010 $60 strike price call option. That sounds complicated, but it is not hard to figure out if you translate it word by word. This option gives you the right to purchase 100 shares of GDX at a price of $60 per share on a set date in January 2010.

Let's say you purchase such an option, and a year later want to get out of the position. If GDX stock is trading for $60 per share on that date, you could "exercise" your option by purchasing 100 shares of GDX at $60 per share, and then turn right around and sell the stock back into the market at the current price of $60 per share. No speculator in their right mind would ever do that at that price because the purchase and sale would cancel each other out, and they would lose money due to the transaction costs (brokerage commissions) involved in executing those trades. For the same reasons, you would not want to exercise the option if GDX stock was trading below $60 per share, since you would lose money if you bought 100 shares at $60 each and then sold them at the lower current market price. That is why the majority of options expire worthless and are never exercised.

That brings us to the profitable case - when GDX shares are trading above the strike price of the option when you exercise it. For example, if GDX shares are trading at $70 per share, you can exercise your option and buy 100 shares at $60 each for a total cost to you of $6,000. You can then turn right around and immediately sell those shares in the open market for $70 per share (the current market price) for a total of $7,000, giving you a quick $1,000 profit.

So how does the potential profit from buying options compare to the potential profit from just buying regular shares in an ETF or stock? Let's look at an example.

If an investor purchased $10,000 of GDX shares at $50 per share in 2007 and then sold them when the price of GDX stock increased to $60 per share in 2008, he would make a profit of $2,000 (excluding transaction costs). But if the same investor instead purchased $10,000 of GDX call options when GDX was trading at $50 per share, and then sold or exercised them when the price of the common stock increased to $60 per share, he would have a profit of approximately $10,000 instead, a result five times better than just buying shares of the common stock. This is the power of leverage in action.

So what's the downside - why doesn't everybody just buy options instead of stocks?

There are two reasons. First, stocks do not have expiration dates. If a stock moves against you, you could hold it for literally years waiting for it to come back to your break even point. If you hold an option to its expiration date and it expires at or below its strike price, it expires worthless and you lose your entire purchase price. Most investors do not realize that there are two simple solutions to this dilemma - either sell the option to another investor in the market if its value falls to your mental stop loss position (that way you only lose as much of your investment as you decide prior to the trade you are willing to risk on that one position), or "roll" the option. Rolling over an option means that you sell an option that is about to expire while there is still some profit that can be extracted from it, and then immediately turn around and purchase an option at the same strike price that expires at a later date. In this manner, you never have to reach an expiration date unless you want to.

The second reason most investors purchase stocks instead of options is that they are unfamiliar with options and if they know about them at all consider them to be too exotic and risky for normal investors to trade. As discussed in the preceding paragraph, there are loss mitigation strategies that can make trading options no more risky than trading common stocks - and options have far more profit potential than shares of common stock.

In the last post, we talked about two ETF's to play the ongoing appreciation of the gold price - GLD and GDX. GLD unfortunately does not have any listed options, so you have to purchase common shares. But GDX does offer options, and as mentioned previously, if you'd like to dip your toe in the water and experience the superior profit potential that comes from trading options, your best bet is most likely the January 2010 $60 call option. This option has lots of time left on it until it expires, and I can think of no scenario in which the price of gold will not be significantly higher at sometime in the next two years.

If you have never traded options before, getting started is easy. Most brokers just ask you to fill out a form and mail it in to them and then they give you permission to trade options. Some online brokers will even allow you to apply online and save the cost of the envelope and stamp if you already have a brokerage account with them. Good luck!